Outreach Blog

Tuesday, April 15, 2014

Controversial OFR Report Yields Some Valuable Findings

What We Don’t Know is as Dangerous as What We Do


Author: David Schwartz J.D. CPA

The September 2013 Office of Financial Research (OFR) report entitled “Asset Management and Financial Stability” attempts to present a critical analysis of how asset management firms and the activities in which they engage can introduce vulnerabilities that could pose, amplify, or transmit threats to financial stability.  The report’sassumptions and conclusions have provoked some very strong responses from members of the asset management industry, commentators, and even some legislators. Despite the mixed reviews, the reports yields some very useful findings and analysis.

 
The OFR’s report begins with a comprehensive yet high level review of the asset management industry.  This overview examines the industry from a number of perspectives, including the broad categories of sources of investable assets, the various types of investment vehicles and the managers that provide them, estimates for the top 20 asset managers by AUM and their relationships with their parent companies, and significant asset class business lines of the largest asset managers.  One of the key observations resulting from this review is that the asset management industry is by no means monolithic, but a diverse interaction of a number of very different types of asset managers, investors, investment activities, investment goals, and investment vehicles.  This observation underpins what is perhaps the most important conclusion of the report:  any attempt to analyze or understand the industry must be approached from the perspective of the activities engaged in by asset management industry participants and the respective risks associated with those activities.  
 
[A]sset management firms have a diverse mix of businesses and business models, offer a broad variety of funds, and engage in many activities. This diversity suggests that asset management activities should be the analytical building blocks for understanding the industry. Such an approach permits the flexibility to analyze risks posed by firms (firm divisions, or firms as consolidated entities) or by industry market sectors by aggregating activities and assessing the interplay among them.
 
Notably, this focus on activities for assessing systemic importance appears to have been taken into account by the FSB when formulating their non-bank SIFI consultative document. However, unlike the OFR report, the FSB’s Consultative Document proposes assessing systemic importance at the fund-level, as opposed to at the asset manager-level with all funds combined. Despite this difference, both the OFR report and the FSB seem to agree that the factors that make the industry vulnerable to financial shocks include (1) “reaching for yield” and herding behaviors; (2) redemption risk in collective investment vehicles; (3) leverage, which can amplify asset price movements and increase the potential for fire sales; and (4) firms as sources of risk. Most of the controversy about the OFR’s report stems from disagreement on just how vulnerable
 
According to the OFR, an activities based approach, however, faces some challenges because of some serious gaps in available data.  The report finds that most of the data available to analyze the industry relate to firms or funds, not to activities, and these data gaps are major hurdles to macroprudential analysis from an activities perspective. 
 
 
Significant data gaps impede effective macroprudential analysis and oversight of asset management firms and activities. Data gaps block regulators’ and supervisors’ view of risk-taking, leverage, and liquidity transformation across financial markets and hinder their ability to fully analyze the nature and extent of financial stability risks relating to the asset management industry.
 
 
Some areas where OFR identifies data gaps are separate accounts and securities lending and repo markets. An OFR also notes a serious lack of data on at the asset management firm level. 
 
Separate accounts can be opaque, says the OFR, because data about the types of assets held in these accounts, their counterparty and other risk exposures, and amounts of leverage are limited. Given this limited data, the potential ways that separate account exposures or asset sales could affect markets may not be understood adequately, and regulators do not have the data they need to assess fully the nature or extent of any financial stability risks that could be amplified or transmitted by the activities of these accounts.
 
Data about securities lending and repo activities of asset management firms is also inadequate. What is needed, OFR says, is more transaction level and position data on securities lending between large international financial institutions, including the composition of the underlying cash collateral reinvestment assets.  The Dodd-Frank Act specifically requires more transparency in this area, and the OFR feels that the SEC still has much work to do in this area. 
 
[M]onitoring the reinvestment of cash collateral from securities lending is important for financial stability purposes, but such monitoring is limited by a lack of data. Collecting transaction level and position data on securities lending between large international financial institutions, including the composition of the underlying cash collateral reinvestment assets, would improve regulators’ visibility into market activities.  Section 984 of the Dodd-Frank Act requires the SEC to adopt rules increasing the transparency of information about securities lending available to broker-dealers and investors. Such a rulemaking could fill some of the data gaps described earlier.  Similar concerns exist regarding the involvement of asset managers in repo activity.
 
 
Finally, OFR identifies gaps in the available data at the firm level as a major hurdle to understanding the macroprudential effects of large asset managers. 
 
Many of the largest asset managers are private and do not issue public financial statements. Assessing their financial positions and constructing a complete picture of their activities and interconnections is difficult, if not impossible. Lack of data on these firms limits the ability to assess their financial condition or identify activities, such as excessive borrowing or liquidity transformation, that could pose a threat to financial stability. Given that many large asset managers are private, cross-industry measurements of fundamental metrics, such as overall leverage, are difficult to calculate, which complicates effective macroprudential oversight.
 
Despite the controversy surrounding it, the OFR’s examination of the asset management industry was indeed a worthy exercise, if not for its conclusions, for its analysis and the insight its analysis has provided into where our blind spots may be.  It may be that what we still don’t know about the asset management industry is at least as, if not more important than what we do. 
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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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